Exercise 1 Equilibrium in the Solow-Swan model is characterized by the

market clearing condition S = I. With a fixed savings rate of s, total savings

are S = sY . Investment are given by the increase in the capital stock plus
capital depreciation I = K̇ + δK. Thus market clearing implies

K̇ + δK = sY ⇒ K̇ = sF (K, L) − δK

Now transform this equation into per capita terms by diving through the
total labour force L
 
K̇ K K
= sF , 1 − δ = sf (k) − δk
L L L

and note that

 ˙ 
K K̇L − K L̇ K̇ K̇
k̇ = = 2
= − kη ⇒ = k̇ + ηk
L L L L

from where it follows that

k̇ = sf (k) − (η + δ)k (1)

(a) In steady state k̇ = 0, thus

f (k ∗ )
s =η+δ (2)
k∗
Now we are given a Cobb-Douglas production function of the form

Y = F (K, L) = K 1/3 L2/3

The intensive form of this function is obtained by diving through L

 
K
f (k) = F , 1 = k 1/3
L

Plugging this functional form into the above definition of the steady state
yields
 1
 1−α
s
s(k ∗ )α−1 = η + δ ⇒ k ∗ =
η+δ

1
Per capita output in steady state is
 α
 1−α
s
y ∗ = f (k ∗ ) = (k ∗ )α =
η+δ

(b) Profit maximisation by firms’ leads to the first order condition ( see p.
23 )
f 0 (k) = r + δ
so the real interest rate is given by

r = αk α−1 − δ

In steady state the real interest rate is

α(η + δ)
r∗ = −δ
s

(c) Consumption is equal total production minus savings

C = Y − sY = (1 − s)Y.

So per capital consumption is c = (1 − s)y = (1 − s)f (k). In steady state

 α
 1−α
∗ ∗ s
c = (1 − s)y = (1 − s)
η+δ

and steady state per capita savings are

 α
 1−α
s
sy ∗ = s
η+δ

Exercise 2 The golden rule savings rate, is the savings rate that maximises
steady state per capita consumption over the steady state per capita capital
input. Steady state consumption is given by

c∗ (k ∗ ) = (1 − s)f (k ∗ ) = f (k ∗ ) − sf (k ∗ ) = f (k ∗ ) − (η + δ)k ∗

2
using equation (2) for the last step. If we maximise c∗ w.r.t. s we get the
following first order condition
dc∗
= f 0 (k ∗ ) − (η + δ) = 0.
dk ∗
00
This gives the maximum as c∗ is globally concave in k ∗ : c∗ (k ∗ ) = f 00 (k ∗ ) < 0.
Therefore, the golden-rule level of per capita capital kg is implicitly defined
by
f 0 (kg ) = η + δ (3)

(a) The golden-rule optimal level of per capita output is

αkgα−1 = η + δ
The steady state level of per capita capital is
 1
 1−α
∗ s
k =
η+δ
If s = α, k ∗ and kg coincide.

(b) If s = 2α, k ∗ > kg and thus the economy is dynamically inefficient.

To see this note that as per capita consumption is maximised at the golden-
rule optimal level of per capita capital, any level of k that exceed kg leads to
00
a drop in steady state per capital consumption ( recall that c∗ (k ∗ ) < 0 and
0
c∗ (kg ) = 0 ). We could therefore decrease savings and increase consumption
at the same time. This could for example be achieved by ”eating” k ∗ − kg of
the capital stock.

(c) Recall the definition of steady state consumption as

c∗ = f (k ∗ ) − (η + δ)k ∗ = (k ∗ )α − (η + δ)k ∗
Now for the golden rule to hold
 
η+δ
αkgα−1 =η+δ ⇒ kgα = kg
α
So    
η+δ 1−α
cg = − (η + δ) kg = (η + δ)kg
α α

3
Now  1
 1−α
α
kg =
η+δ
from where we get
   1
 1−α  2  
1−α α 1 1 1
cg = (η + δ) = (η + δ) =
α η+δ 2(η + δ) 4 η+δ

for α = 0.5. So  2
∂cg 1 1
=− <0
∂η 4 η+δ

Exercise 3 (a)and(b) ( see exercise 1(a) )

log10 k ∗
s =η+δ
k∗

(c) ( see exercise 4(d) )

Exercise 4 (a) Again the steady state per capital capital stock is charac-
terised by equation (2).

f (k ∗ )
s = η + δ ⇒ s(k ∗ )−1/3 = η + δ
k∗
so the steady state capital stock is
 3/2
∗ s
k = .
η+δ

(b) Firms’ profits are given by

pr = [(1 − δ)k + f (k)] − (1 + r)k

Profit maximisation implies to following first order condition

2
f 0 (k) = r + δ = π ⇒ π = k −1/3 .
3

4
So in the steady state profit rate is
 1/2
2 2 η+δ
π = (k∗)−1/3 =
∗
3 3 s

The wage rate is the marginal product of labour

∂ ∂
w= F (K, L) = [Lf (k)] = f (k) − kf 0 (k)
∂L ∂L
So the steady state wage rate w∗ is
 
∗ ∗ 2/3 2 1 1 s
w = (k ) − (k ∗ )2/3 = (k ∗ )2/3 =
3 3 3 η+δ

(c) Per capita savings are sy ∗ = sf (k ∗ ) = s(k ∗ )2/3 and per capital consump-
tion is c∗ = (1 − s)(k ∗ )2/3 .

(d) Initially the economy is in steady state, with zero growth. Let’s call
this steady state k1∗ :

γk = s(k1∗ )2/3 − (η + δ)(k1∗ ) = 0

For this capital stock, if the savings rate rises to s0 > s, the growth rate of
the capital stock γk will become positive

γk = s0 (k1∗ )2/3 − (η + δ)(k1∗ ) > 0

The economy will start growing, both per capital capital and output go up.
This will continue until the economy reaches its new steady state k2∗ > k1∗

s0 (k2∗ )2/3 − (η + δ)(k2∗ ) = 0

at which both per capita capital and output are higher than in the previous
steady state. Per capita growth rates are however again zero.

(e) The golden-rule optimal per capita capital stock is given by

  32
2 2
f (kg ) = η + δ ⇒ kg−1/3 = η + δ ⇒ kg =
0
3 3(η + δ)

5
The steady state capital stock is given by
 3/2
∗ s
k =
η+δ

The economy is dynamically inefficient if k ∗ > kg , i.e.

 3/2  3/2
s 2 2
> ⇒s>
η+δ 3(η + δ) 3

irrespective of the value of δ and η.

Exercise 5 (a) ( see exercise 4(a) )

 2
∗ s
k =
η+δ

(b) ( see exercises 4(b) and (c) )

1
π ∗ = (k ∗ )−1/2
2
1
w = (k ∗ )1/2
∗
2
sy ∗ = s(k ∗ )1/2
c∗ = (1 − s)(k ∗ )1/2

As can easily be seen, the steady state capital stock declines as η increases.
Thus wages, pc savings, and pc consumption fall when η increases. The profit
rate however rises, as capital becomes relatively scarce as compared to labour.

(c) ( see exercise 4(e)and 2(a) ) The economy is dynamically inefficient as

long as s > 1/2 irrespective of η.

Exercise 6 We will consider the fixed proportion ( Leontieff ) production

function  
K L
Q = F (K, L) = min ,
a b
with a > 0 and b > 0.

6
a. 1) Calculate the marginal product:

Let us first calculate the marginal product of capital. We will have to con-
sider 2 cases
i) K/a < L/b and ii) K/a ≥ L/b

i) for K/a < L/b the production function will be

K
Q=
a
and thus the marginal product of capital will be
∂Q 1
= >0
∂K a
ii) for K/a ≥ L/b the production function is
L
Q=
b
and the marginal product
∂Q
=0
∂K
Same procedure for the marginal product of labour
i) for K/a < L/b  
∂Q 1 K
= =0
∂L ∂L a
ii) for K/a ≥ L/b  
∂Q 1 L 1
= = >0
∂L ∂L b b
2) Average products:
The average product of capital is defined as Q/K, thus
i) for K/a < L/b, Q/K = 1/a
ii) for K/a ≥ L/b, Q/K = L/(bK)

The average product of labour is Q/L, thus

i) for K/a < L/b, Q/L = K/(bL)
ii) for for K/a ≥ L/b, Q/L = 1/b.

graph for unit isoquant here

7
b. 1) Definition: A product function has constant returns to scale (CRS),
if for all λ > 0
F (λK, λL) = λF (K, L)
Let’s verify this for the fixed proportions production function
   
λK λL K L
F (λK, λL) = min , = λ min , = λF (K, L)
a b a b

So this production function indeed has constant returns to scale.

2) Definition: A function f : X → R is quasi-concave if for x, y ∈ X

we have
f (λx + (1 − λ)y) ≥ min {f (x), f (y)}
for all 0 < λ < 1. ( Note: Any concave function is also quasi-concave. The
reverse is not necessarily true. )

So let’s check this for our fixed proportions production function. Take two
admissible values (K1 , L1 ) and (K2 , L2 ). Then
   
λK1 + (1 − λ)K2 λL1 + (1 − λ)L2 λK1 + (1 − λ)K2 λL1 + (1 − λ)L2
F , = min ,
a b a b
    
K1 L 1 K2 L 2
≥ min min , , min , = min {F (K1 , L1 ), F (K2 , L2 )}
a b a b

So this function is indeed quasi-concave.

3) To see that both factors are essential, simply note that F (0, L) = 0,
and F (K, 0) = 0.

c. To solve for Solow’s basic differential equation, let us first transform

the production function into intensive form. As we have shown that the
production function has constant returns to scale, we can simply divide it by
L to get  
k 1
f (k) = min ,
a b
For all k/a ≤ 1/b, the production function will be f (k) = k/a, for all
k/a > 1/b it will be f (k) = 1/b.

8
So we get two basic differential equations depending on these two cases:

i) for k/a ≤ 1/b:

k̇ s
= − (η + δ)
k a
ii) for k/a > 1/b:
k̇ s
= − (η + δ)
k bk

Let us assume that s/a > η + δ, for otherwise k would always decrease, and
the only possible steady state would be k ∗ = 0. With this assumption, the
capital stock k will eventually exceed the value of 1/b and thus the steady
state is defined by
s s
∗
= (η + δ) ⇒ k ∗ =
bk b(η + δ)

The real rental rate π is given by

π = f 0 (k)

Thus, for k/a < 1/b, π = 1/a, and for k/a > 1/b, π = 0. ( Note that there is
a kink in the production function at k = a/b, so the derivative at this point
is not well defined. )
Real wages w are given by

w = f (k) − kf 0 (k)

Thus for k/a < 1/b  

k 1
w = −k =0
a a
and for k/a > 1/b, w = 1/b.

So suppose we start with an initial level of per capita capital below a/b. Then
initially capital is relatively rare and labour is relatively abundant. The wage
rate will be zero, the rental rate will be positive. The capital stock will start
growing until it reaches its steady state value of k ∗ > a/b. Once k exceeds
a/b labour will now be relatively scarce and the factor capital abundant, thus

9
the rental rate will drop to zero, the wage rate will suddenly become positive.
At k = a/b, the exact rental and wage rate cannot be pinned down. Any
values for π and w such that f (a/b) = w + π(a/b) are possible. ( Remem-
ber that the isoquants of this production function have a kink at K/a = L/b.)

The output - capital ratio is given by Q/K. We can divide both numer-
ator and denominator by L to see that this is equivalent to f (k)/k. So the
capital - output ratio is

i) for k/a ≤ 1/b, f (k)/k = 1/a

ii) for k/a > 1/b, f (k)/k = 1/(bk).

10